Invest Like a Rat

In the October 2013 issue of Research Magazine, Bob Seawright writes about a study mentioned in the book Expert Political Judgment. The study involved rats looking for food that was placed at one of the two ends of a T-maze. Before the rats were released, individuals were asked to predict which end of the maze held the food. The study was designed so that the food was placed randomly at one of the two ends each time, but one side of the T-maze ended up with the food 60% of the time.

The rat quickly figured out which side had food most often and would run straight to that side each time. Since that side had a 60% chance of having food, always running to that side of the T-maze meant that the rat guessed correctly 60% of the time.

Seawright explains that humans have a hard time dealing with randomness, so we tend to look for patterns even where they might not exist. The individuals in the study tried to find a pattern to where the food was being placed, and this led to participants basing their guesses on the recent position of the food. The humans were right only 52% of the time.

The study in this article got me to thinking about how the investment world is filled with people trying to find patterns where they might not exist. Instead of buying an index fund to capture as much of the market’s return as possible, most investors opt for higher-cost actively managed funds that offer the chance to beat the market. Unfortunately, the odds are against them.

One of my favorite sources of information on the active vs. passive debate is the S&P Indices Versus Active Funds Scorecard (SPIVA). The year-end 2015 SPIVA report found that less than 17% of actively managed US equity mutual funds outperformed their index for the 10-year period ending December 31, 2015. This means that 83% of mutual funds failed to earn the average return of the market.

Let’s compare this to how a rat might invest. The stock market goes up around 70% of the time, and market indexes tend to rise more days than they decline even during bear markets. So a rat would probably realize this fact, buy a few low-cost index funds that cover different asset classes, and give up trying to time the market.

And by doing this year after year without regard to the latest economic noise, a rat would end up outperforming most of the highly paid investment managers with a lot less stress in the process!